Consumer spending holds up even as real incomes slump

The level of consumer spending has held up despite real incomes slumping from their COVID hand-out inflated peak, where income has been dragged lower by still-high inflation, near-record income tax and higher interest payments.  Real income should stabilise and eventually recover as inflation is brought under control, but in the meantime it seems likely that spending should be supported by households continuing to tap the record excess savings buffers accumulated at the height of the pandemic.    

Consumer spending is difficult to model and very difficult to forecast, where mistakes in forecasting spending often drive the RBA’s forecast misses for GDP, which is not surprising given that spending accounts for about half of output. 

Over recent years, spending has become even harder to predict because of the unprecedented distortions created by COVID, where spending collapsed during mandated and self-imposed lockdowns and income surged on record government hand-outs (like other countries, there were also unprecedented swings in the composition of spending, where spending on goods boomed at the height of COVID and spending on services collapsed).

In estimating consumer spending, the two main influences on consumption are income and wealth, where the impact of wealth is usually relatively small and often drawn out. 

During the pandemic, the massive gap that opened up between income and spending allowed households to accumulate record excess savings of 13% of GDP, which CCI calculated by comparing COVID-era cash flows with their estimated pre-pandemic trend.* 

These excess savings are in turn embedded in net household wealth, which is at a near-record level of 9.5 times annual income.

Recently, though, household income has fallen sharply in real terms, down 6% from its handout-boosted peak and 4% lower over the past year.  

The sharp fall in real income reflecting still-high inflation, a near-record income tax take, and higher interest payments. 

Normally such a large decline in income would cause spending to fall, albeit in a more muted fashion given households tend to smooth their consumption.

However, to date, spending has held up, posting very weak growth until it stalled in Q3 on the distortion created by the accounting treatment of direct government “cost-of-living” subsidies. 

Subsidies distorted growth because the ABS accounted for them by reducing consumer spending on utilities – which fell by a record 17% in the quarter - and counting the expenditure instead as government consumption in the quarter. 

The ABS does not publicly quantify these subsidies, but as a rough guide to their impact real spending excluding utilities rose by 0.4% in Q3 after a flat Q2.

Looking past this distortion, growth in spending seems likely to remain very weak, such that the level of spending should broadly hold up as real household income stabilises over the course of next year as inflation falls and with consumers tapping the pool of excess savings built up during COVID. 

Households have already curbed their saving, having almost spent all their income in net terms in Q3, and look to have recently started to draw on their excess savings buffers. 

Based on the experience of the US and euro area – where estimated savings buffers are now near exhaustion – the pool of excess savings provides scope for the level of household spending to hold up until real incomes eventually resume growing, most likely in 2025. 

Whether or not households draw down all their excess savings is unclear, as the peak buffer in Australia was much higher as a share of GDP (and household income) than the peaks recorded in the US and euro area, and it may be that some of the money is retained in order to shore up household finances.

Note: * CCI estimates of excess savings will be updated when Q3 data are released later this month.